Wednesday, 15 January 2014

Why a house isn't worth what an owner thinks it is

There's a house for sale near my place that has been on the market for months while everything around it has sold. This is a classic case where Behavioural Economics (BE) can explain why.

Here is the house at 237 Princes St Port Melbourne as it actually is.

And here is the house as the owner sees it, after the new owner buys it, knocks it down, and builds to the approved plans that the owner has paid a substantial sum for.

Two BE principles at play

There are two main BE stories here: sunk-cost bias and the endowment effect.

Sunk cost bias:

The owner has spent money on getting these plans prepared and approved. He wants to get a return on that spend. The problem is that this is now a sunk cost.

Let's imagine that he instructed his architect and town planner to design an 8-storey tower on the block for 4 separate apartments. And let's say that the architect and planner told him he was completely mad and it would never be approved, yet he insisted they do the work. So, $50,000 later and the proposal is rejected. That $50,000 is clearly a sunk cost. It's never going to be recovered, much like backing a loser at the racetrack.

In this case, though, it's a bit more subtle. The work was done, the approvals have been achieved, and there is some value in that. Yet, it's still a sunk cost. It's been spent. Any focus on what's been spent has no bearing on what the market will pay. The owner is still fixated on the past. The buyers are only interested in the present and future.

The endowment effect:

This is even more emotional, and has a substantial impact on the owner's state of mind. He has owned this property for some time and has put in a lot of effort (that he "owns") to ready it for sale. BE research shows that his value on the property is much higher than a potential buyer's value. In some studies by a factor of 14!

No deal!

So, we have a situation where the owner feels that the property is worth $850k or more and the buyers clearly do not. No deal will be done here until the owner can rid himself of the sunk cost bias and endowment effect. The buyers will not shift their view.

Of course, there are a lot of other complicating factors in a real estate market but this case shows how important the BE factors are. And they impact on everyone, on major commercial deals worth hundreds of millions a single house like this or even the purchase of a new kettle.

This new blog, Behavioural Economics Australia will explore these fascinations.

Let me know what you think

Mark Solonsch


  1. It'll sell when the seller's blood finally bleeds dry. Rational human behavior is totally distorted by bad housing policy. In the US he'd wait until the Fed's QE reinflated his sense of value.

    1. Hi Policritic, it's a bit different here. Over the past year, house prices in Melbourne increased by 7.1%, and in this premium suburb, the increase was a little higher.
      So, Daniel Kahneman might say that his System 2 thinking is using those "hard" statistics on price rises to provide some justification to System 1's more emotive decision making that is really at play.